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Untangling tight knots

Cross-shareholdings in Japan

We all support our friends and do them favours, especially if we have known them for a long time and developed mutual trust. However, this perfectly acceptable behaviour can lead to a series of problems when it applies to relationships between listed companies, as it does in Japan. The practice of cross-shareholdings or strategic shareholdings, whereby companies hold shares of each other, is common among Japanese companies in order to maintain good business relationships. While the practice may have helped grow and protect Japanese businesses in the past, it is now increasingly seen as problematic by investors.

BackgroundCross-shareholdings began after World War II when large conglomerates, the so-called zaibatsu, which were perceived to have excessive influence over the Japanese economy, were broken up into separate entities such as banks, trading houses and manufacturers. The companies continued to maintain strong ties through cross-shareholdings, as well as trading among themselves and interlocking their boards. However, some of these holdings are unilateral and hence not technically cross-shareholdings. For instance, a supplier may hold shares of its buyer to secure sales. In addition, cross- or strategic shareholdings are not limited to former zaibatsu companies and strong business relationships have been built on cross-shareholding. Banks in particular have played a significant part by acquiring shares of a large number of companies to which they lent money, while life insurance companies have also been a major contributor to this system.

Although they have begun to decline, with holdings by banks and life insurance companies falling from over 40% of listed stocks in the late 1980s to below 20%, cross-shareholdings still account for a substantial part of the Japanese equity market. Even so, the three largest banks of Japan continue to hold shares of thousands of companies each, amounting to over JPY 10 trillion ($100 billion) as of June 2016[1]. Holdings by non-financial companies meanwhile have remained at around 24%.

Need for untangling But for various reasons, cross-shareholdings are increasingly seen as difficult by investors. Firstly, the selection of business partners based on shareholding relationships is not consistent with market principles and can obstruct fair competition. Companies should choose business partners that provide the best quality products and services at the most competitive price. We are extremely concerned that many companies are obliged to hold shares of other companies in order to maintain a business relationship with them.

Another problem is that this type of shareholdings can lead to poor corporate governance. When companies hold shares of others to maintain good relationships, they tend to support the management of the investee companies instead of exercising their voting rights appropriately to hold management to account. We believe this contributes to sustaining poor governance practices and blocking attempts by other investors to reform companies. In addition, these shareholdings can be used as anti-takeover measures.

It is also important to note that while this practice is designed to benefit certain owners – those who have a strategic interest in the investee companies by securing contracts for example – other shareholders will not see any tangible benefits. This means shareholders are not treated equally.

Breaking the deadlockMany companies believe that selling shares of their business partners would negatively affect their relationships, leading to the destruction of shareholder value. However, pressure to dissolve cross- or strategic shareholdings has been mounting. In addition to the Corporate Governance Code’s requirement for companies to disclose their plans on cross-shareholdings, the Japanese government has encouraged the country’s three major banks to reduce these.

We have been engaging with various stakeholders on this matter, including regulators and companies, raising awareness and pressing for change. We have encouraged the regulator to introduce a rule for companies to disclose their cross-shareholdings as we believe detailed disclosure will help begin to untangle the resulting relationships.

Realistically however, it will take time to abolish this practice as it spans across the interests of many parties.

[1] According to figures disclosed in the companies’ financial documents submitted to FSA.

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Sachi SuzukiSachi Suzuki is sector lead for industrials and responsible for engagement activities mainly in Japan and southeast Asia. Prior to joining Hermes EOS, she worked as a senior research analyst at EIRIS where she was responsible for the assessment of the ESG performance of Japanese companies, as well as research on bribery and corruption. Sachi graduated from Keio University in Japan with a degree in Economics and holds an MSc in Development Studies from the School of Oriental and African Studies, University of London. She holds the CFA Institute’s Investment Management Certificate. Read all articles
by Sachi Suzuki